Share this post:
Accruals and prepayments are the topic that separates students who understand accounting from students who are simply memorising it. They are also, reliably, one of the biggest sources of lost marks at AAT Level 3. The good news is that once the underlying idea clicks, the whole topic becomes far more logical than it first appears. This guide is designed to make it click.
We will cover the matching concept that sits underneath everything, the difference between the two adjustments, the journal entries, and worked examples for each. If you have already worked through our guides to double entry bookkeeping and the trial balance, this is the natural next step in building real accounting understanding.
Accruals and prepayments are year-end adjustments that make sure income and expenses are recorded in the correct accounting period, regardless of when the cash actually moves. They exist because the date money leaves or enters a bank account is often not the same as the date the expense or income actually belongs to.
In short: an accrual is an expense (or income) that belongs to this period but has not yet been paid or received. A prepayment is an expense (or income) that has already been paid or received but belongs to a future period. Both adjustments pull the numbers into the right period so the accounts tell the truth about that period’s performance.
Everything about this topic flows from one principle: the matching concept, also called the accruals concept. It states that income earned must be matched with the expenses incurred to earn it, within the same financial period, regardless of when cash is paid or received.
Think about it logically. If a business pays three years of rent upfront, does that mean it has no rent expense in years two and three? Of course not. It still uses the property and still incurs the expense each year, it has simply paid in advance. The matching concept ensures each year’s accounts show the rent that genuinely relates to that year. Accruals and prepayments are just the mechanical tools that make this happen. Once you see them as servants of the matching concept rather than arbitrary rules, they stop feeling random.
An accrued expense is a cost that belongs to the current period but has not yet been paid or invoiced by the year end.
Example. A business has a 31 December year end. In late December it uses electricity, but the £200 bill will not arrive until January. That £200 of electricity was consumed this year, so under the matching concept it must appear in this year’s accounts, even though it has not been paid.
The double entry is: debit the electricity expense account £200 (increasing this year’s expense in the profit and loss account), and credit the accruals account £200 (creating a current liability on the statement of financial position, because the business still owes the money). When the bill is paid in January, the accrual reverses.
A prepaid expense is the opposite: a cost that has been paid this year but relates, wholly or partly, to next year.
Example. The same business pays a £1,200 annual insurance premium on 1 October, covering twelve months to the following September. By the 31 December year end, only three months (October to December) of that cover has actually been used. The remaining nine months, £900, belongs to next year.
The adjustment is: debit the prepayments account £900 (creating a current asset on the statement of financial position, because the business has effectively paid for something it has not yet received), and credit the insurance expense account £900 (reducing this year’s expense so only the £300 actually used remains). Next year, the prepayment reverses and becomes that year’s expense.
The same logic applies to income, just mirrored. This is where many students lose confidence, but the principle is identical, only the direction changes.
Accrued income is income earned this period but not yet received, such as interest earned but not yet credited. The double entry is debit accrued income (a current asset) and credit the income account in the profit and loss.
Prepaid income, sometimes called deferred income, is income received this period but relating to a future one, such as a customer paying in advance for a service you have not yet delivered. The double entry is debit the income account and credit prepaid income (a current liability), because you owe the customer the service.
Students frequently mix up which adjustment creates an asset and which creates a liability. Here is the logic that keeps it straight, no memorisation required.
If you owe something, it is a liability. An accrued expense means you owe money you have not paid, so it is a liability. Prepaid income means you owe a service the customer has paid for, so it too is a liability.
If you are owed something, it is an asset. A prepaid expense means you have paid for something you have not yet received, so the business is effectively owed that benefit: an asset. Accrued income means you are owed money you have earned but not received: an asset.
Work from “do I owe, or am I owed?” and you will never place an accrual or prepayment on the wrong side of the statement of financial position again.
These adjustments do not just move numbers around for the sake of it. They directly change reported profit, which is exactly why they matter and why examiners test them so heavily.
Adding an accrued expense increases expenses and therefore reduces profit for the period. Recognising a prepaid expense reduces expenses and therefore increases profit for the period. On a small scale the amounts may seem trivial, but scaled up across a large organisation with many transactions, failing to apply accruals and prepayments correctly would distort the profit figure significantly and give a misleading picture of performance.
This topic is core to AAT Level 3, particularly the Financial Accounting: Preparing Financial Statements (FAPS) unit, which is widely regarded as one of the toughest Level 3 assessments. Adjustments for accruals and prepayments appear both as standalone tasks and as part of larger financial statement preparation questions.
They also underpin the extended trial balance, where these adjustments are applied before the final accounts are produced. If you are preparing for FAPS specifically, our dedicated guide on how to pass AAT FAPS covers the wider unit, and our guide to the trial balance explains the stage these adjustments build on.
The reason accruals and prepayments cause so much difficulty is that they require applying theory, proportioning amounts across months, and making adjustments in reverse, all at once. That combination is exactly where practice with instant feedback makes the biggest difference.
AI Accounting Tutor lets you work through adjustment questions at your own pace, upload a question you are stuck on, and get a clear step-by-step explanation of which account to debit, which to credit, and why. This is core content for AAT Level 3, and once you are confident, you can test yourself under timed conditions using our guide to AAT mock exams.
Accruals and prepayments are year-end adjustments that ensure income and expenses are recorded in the correct accounting period, regardless of when cash is paid or received. An accrual relates to something belonging to this period but not yet paid or received; a prepayment relates to something already paid or received but belonging to a future period.
An accrual is an expense or income that belongs to the current period but has not yet been paid or received. A prepayment is an expense or income that has already been paid or received but belongs to a future period. They are effectively opposites of each other.
The matching concept, also called the accruals concept, states that income earned must be matched with the expenses incurred to earn it within the same financial period, regardless of when the cash is actually paid or received. It is the principle that accruals and prepayments exist to apply.
For an accrued expense, you debit the relevant expense account (increasing the expense in the profit and loss) and credit the accruals account (creating a current liability on the statement of financial position, because the money is still owed).
For a prepaid expense, you debit the prepayments account (creating a current asset) and credit the relevant expense account (reducing this period’s expense so only the portion actually used remains in the accounts).
A prepaid expense is an asset, because the business has paid for something it has not yet received and is effectively owed that benefit. Prepaid income, on the other hand, is a liability, because the business has been paid for something it still owes the customer.
An accrued expense is a liability, because the business owes money it has not yet paid. Accrued income is an asset, because the business is owed money it has earned but not yet received.
Adding an accrued expense increases expenses and reduces profit for the period. Recognising a prepaid expense reduces expenses and increases profit. Applying these adjustments correctly ensures the reported profit accurately reflects the period’s true performance.
Deferred income, also called prepaid income, is income received during the current period that relates to a future period, such as a customer paying in advance for a service not yet delivered. It is treated as a current liability until the service is provided.
Accruals and prepayments are core to AAT Level 3, especially the Financial Accounting: Preparing Financial Statements (FAPS) unit. They appear as standalone adjustment tasks and within larger financial statement questions, and they are one of the most common places students lose marks, making them essential to master.
This article provides general educational guidance on accruals and prepayments for accounting and bookkeeping students. Always refer to current AAT study materials and assessment guidance for your specific unit.
Share this post:
Support Team
I will be back soon
